Tuesday, March 9, 2010

Rates Strategy Update: Temporarily back to neutral

I adopted a neutral strategic outlook and a negative tactical outlook on Feb 18(see: Rising risks of a rise in yields). While initially bond yields rose (on the back of the discount rate hike in the US), they have fallen back subsequently and are currently some 10bp lower. I continue to expect especially April and May to provide a challenging environment for government bonds with a likely significant rise in yields into mid-year. Reasons are the adverse winter weather which led to a more pronounced seasonal downswing in economic activity, but should be followed by a more pronounced upswing later on. Furthermore, April and May are usually the cruellest months for bond investors (I will write more on both at a later stage). Finally, while government bond supply will continue unabated, the US Fed's buying of MBS is drawing to an end at the end of this month.
Therefore, I continue to see a pronounced risk of a significant rise in yields over the next months. However, over the next 2-3 weeks, the balance of risk is favouring a different view and I therefore adopt a neutral tactical outlook with a bullish tilt, looking to re-enter shorts at a later stage.
A) Positioning: Short positions have been reduced somewhat since the extremes reached in mid-January. However, they still do not seem to be at a level which historically has been associated with a significant move higher in yields. The chart below shows the aggregated positioning by non-commercial accounts in the US 2y, 5y, 10y & 30y futures (weighted by the respective pvbp of the futures contract). The last data point relating to March 2nd is marked in red.

Aggregated positioning by non-commercial accounts in US bond futures

Source: CFTC, Research Ahead

b) The weather: I have written several times on this subject (see for example: Here Comes the Weatherman II dated Feb 25). Unfortunately, the weather has remained colder than is usually the case going into March. The table below shows the population weighted heating degree days (HDD) per week for the US as well as the deviation from the historic norm for that week. A positive deviation means that there were more heating degree days and in turn the average weather was colder than is usually the case.

Week ending

Heating Degree Days

Deviation from norm

02. Jan 10

222

19

09. Jan 10

256

49

16. Jan 10

211

2

23. Jan 10

164

-44

30. Jan 10

198

-7

06. Feb 10

210

11

13. Feb 10

225

34

20. Feb 10

196

16

27. Feb 10

188

20

06. Mrz 10

172

15

Source: NOAA

The year started colder than usual with a milder period in the second half of January. Thereafter, the weather turned colder again and has remained so for the past five weeks. Again as a reminder a stronger-than-usual winter should be especially bad for retails sales, construction activity & home sales. Given that it seems to last well into March and March is usually a month with a high seasonal acceleration in economic activity, the seasonally adjusted data for early March promise to turn out relatively weak. In turn, bond markets are likely to remain supported for the next 2-3 weeks.
c) Technicals: So far the technical picture does not provide a sell signal. While bond markets were overbought in the midst of February when I suggested a tactical short, this situation has corrected in the meantime and I would consider technicals as largely being neutral with a bullish tilt as the bullish trends in the 10y UST and Bund future contracts remain in place. The chart below tries to highlight this situation for the 10y US future. The bearish trend-line which was about to be formed by the highs reached in late November and early February was broken to the upside whereas the two upward slopinng trendlines (one since July last year and one in place since the start of this year) are still in place.

10y US Treasury future still guided by upward sloping trend

Source: Bloomberg

Overall, I still look for a potentially significant rise in yields during April/May and stick to a neutral strategic view. However, the next 2-3 weeks might rather see a temporary move lower in both, US and Eurozone yields. In turn, I change my tactical outlook from negative to neutral with a bullish tilt, looking to re-enter shorts at a later stage.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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